The price of water is increasing—sometimes dramatically—throughout the world. Over the past five years, municipal water rates have increased by an average of 27 percent in the United States, 32 percent in the United Kingdom, 45 percent in Australia, 50 percent in South Africa, and 58 percent in Canada. In Tunisia, the price of irrigation water increased fourfold over a decade.

A recent survey of 14 countries indicates that average municipal water prices range from 66¢ per cubic meter in the United States up to $2.25 in Denmark and Germany. Yet consumers rarely pay the actual cost of water. In fact, many governments practically (and sometimes literally) give water away for nothing.

The average American household consumes about 480 cubic meters (127,400 gallons) of water during a year. Homeowners in Washington, DC, pay about $350 (72¢ per cubic meter) for that amount. Buying that same amount of water from a vendor in the slums of Guatemala City would cost more than $1,700.

The price people pay for water is largely determined by three factors: the cost of transport from its source to the user, total demand for the water, and price subsidies. Treatment to remove contaminants also can add to the cost.

The cost of transporting water is determined largely by how far it has to be carried and how high it has to be lifted. Growing cities and towns may have to go hundreds of kilometers to find the water needed to satisfy their increasing thirst. California cities have long imported water from hundreds of kilometers away. And China is constructing three canals that are 1,156 kilometers, 1,267 kilometers, and 260 kilometers long to transfer water from the Yangtze River to Beijing and other rapidly growing areas in the northern provinces.

Pumping water out of the ground or over land to higher elevations is energy-intensive. Pumping 480 cubic meters of water a height of 100 meters requires some 200 kilowatt-hours of electricity. At a price of 10¢ per kilowatt-hour, the cost is $20—not including the cost of the pump, the well, and the piping. One hundred meters is not an unusual lift for wells tapping falling supplies of groundwater. In Beijing and other areas in northern China, for instance, lifts of 1,000 meters are sometimes required.

Mexico City, at an elevation of 2,239 meters, has to pump some of its water supply over 1,000 meters up a mountain. The operating costs alone amount to $128.5 million annually. Pumping this water requires more energy than is consumed overall in the nearby city of Puebla, home to 8.3 million people. Amman, Jordan, faces a similar problem related to delivering water to higher elevations.

In most places water is not purchased or exchanged in a market. But formal water markets are developing in the western United States, Australia, and Chile. Where these water markets do exist, they provide examples of how high the scarcity value of the water—that is, the amount that other potential users would be willing to pay for it—can be. Water prices in Australia’s markets peaked at near 75¢ per cubic meter in December 2006, climbing 20-fold in a year in part due to prolonged drought. In the U.S. West, water prices typically range between 3¢ and 10¢ per cubic meter. This is just the cost of the water itself and does not include the expense of treating or transporting it. In some western U.S. cities, water is so scarce that cities are selling sewage effluent for as much as $1 a cubic meter to be used for irrigating gardens.

In India, water scarcity has prompted some farmers to profit by selling their water instead of farming. The water they formerly used to irrigate their crops is instead pumped from their wells and trucked to nearby cities. The farmers are harvesting water rather than food and at the same time promoting a rapid drop in underground water tables.

The final factor affecting how much people pay for water is the amount it is subsidized. Water subsidies can be very large. For instance, water revenues in the city of Delhi are less than 20 percent of what it spends each year to provide water. On average worldwide, nearly 40 percent of municipal suppliers do not charge enough for water to meet their basic operation and maintenance costs.

Subsidies often benefit only higher-income families. Frequently, urban slum residents in developing countries have no access to municipal water supplies and instead purchase water from private purveyors who bring it in by truck. In part because unscrupulous vendors often control this distribution, the prices are very high, typically exceeding $1 per cubic meter. In several Asian cities, for instance, households forced to purchase water from a private vendor pay more than 10 times as much as middle-income families who are connected to the municipality’s distribution system. The poorest households in Uganda spend 22 percent of their income on water, while those in El Salvador and Jamaica use more than 10 percent of their income to satisfy water needs.

Water subsidies are not limited to the developing world. Farmers in California’s Central Valley, for example, use roughly one fifth of the state’s water and pay on average slightly over 1¢ per cubic meter, just 2 percent of what Los Angeles pays for its drinking water and only 10 percent of its replacement value. One analysis of a new U.S. project in central Utah found that the water it will provide will cost close to 40 times more than irrigators pay for it.

Water is currently managed as if it were worthless instead of the life-sustaining, valuable, and increasingly scarce resource that it is. A key step in moving toward more rational water management is to place a price on water that reflects its value and scarcity. This can, of course, result in substantial price increases that particularly hurt low-income families. The best way to avoid this problem is to use a block rate pricing system where a low level of consumption—that required to satisfy basic needs—is very cheap, while prices increase at higher levels of consumption. In Osaka, Japan, for instance, users pay a set monthly fee that includes 10 cubic meters of water; beyond that prices increase in steps from 82¢ per cubic meter up to $3 or more for high-volume users. In addition, ensuring that the poorest households are connected to a secure water supply can protect them from price gouging by private vendors.

Although pricing water at a reasonable cost can generate political problems in the short run, it can lead to substantial efficiencies in the longer run and eliminate a perverse drain on government budgets. Higher prices will lead farmers and industries to use water more efficiently and encourage households to buy more water-efficient appliances and reduce the amount of water they waste. Many efficiency improvements are relatively inexpensive, and most pay for themselves. Any improvement that reduces hot water use, for instance, can pay for itself over time because it saves energy as well as water.

Indeed, there are many links between energy and water. Not only are substantial amounts of energy required to extract, transport, and treat water, but just as the oil price shocks of the 1970s stimulated energy conservation, so too could pricing water to better reflect its real cost stimulate similar conservation efforts by industries, farmers, and households.